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Stock Market Predictability Essay

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I will now examine the effectiveness of the Book to Market ratio in predicting stock market returns. The Book to Market ratio is used to compare the book value and the market value of the firm. The book value is calculated by the firm’s accounting worth. The market value is determined by the market capitalization in the stock market. It is then found using the formula, Book Value of the firm / Market Value of the firm. Its purpose is to identify any securities that may be undervalued or overvalued. From the research of Fama and French (1992), we can see the cross sectional variation in stock returns can be shown by the book to market ratio of individual stocks. In Pontiff (1998), there were two measures of the book to market ratio that …show more content…

However, in the paper’s findings, the book to market ratio’s predictive power is more prominent before 1960 as there is no significant relation after 1960. The paper also concludes that “after 1960, the S&P book to market ratio is a better predictor of market returns than is the DJIA book to market ratio and the S&P book value is better than the DJIA book value in predicting market cash flow”. Therefore, the book to market ratio is a good predictor for future market returns as long as we have a measure of book value that has high correlation with future cash flows.

Some financial experts argue that certain macroeconomic variables can be used for predicting stock returns. One such macroeconomic variable is the Consumption to Wealth ratio. I will now examine how effective this variable is in predicting future stock market returns. The expected excess returns vary with the growths and dips in the business cycle, therefore, they should be predictable at different stages of the cycle. To examine the relationship, we note that aggregate consumption, asset holdings and labour income all share the same long term trend, but in the short term they may deviate substantially from one another. According to Lettau Ludvigson 2001, “we study the role of these transitory deviations from the common trend in

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